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Court Must Apply New Standard for ‘Defalcation’

An insurance carrier that had to pay a bond to an estate after debtor, conservator of the estate, forfeited the bond by failing to show cause why he did not file a final accounting, must return to bankruptcy court to show debtor’s bad faith or gross reckless in order to prove the bond debt is nondischargeable due to debtor’s defalcation; as the legal standard for “defalcation” has changed since the bankruptcy court issued its decision, the Harrisonburg U.S. District Court remands the case for further proceedings.

The carrier appeals from a bankruptcy court decision denying summary judgment on the nondischargeability issue.

On appeal, the parties do not dispute that the debtor was acting within his fiduciary capacity when this debt arose. Thus, the question is whether or not the debt arose from debtor’s defalcation. While the Bankruptcy Code itself does not define defalcation, the Supreme Court recently did so in Bullock v. BankChampaign NA, 133 S.Ct. 1754 (2013), holding that defalcation includes a culpable state of mind requirement, one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.

At the time the bankruptcy court issued its opinion, the 4th Circuit, under In re Uwimana, 274 F.3d 806 (4th Cir. 2001), did not require a showing of recklessness or intentional misconduct in order to find that debtor had defalcated and the related debt was nondischargeable. Given the holding in Bullock, the carrier must make a showing of bad faith or gross recklessness, i.e., that debtor consciously disregarded a substantial and unjustifiable risk that his conduct violated a fiduciary duty, before the court may find that debtor committed defalcation and the bond debt is nondischargeable.

Given the standard in the 4th Circuit at the time the bankruptcy court made its decision, the record as it pertains to debtor’s state of mind at the time he failed to file an accounting and failed to remit the funds to the estate is incomplete. Thus, in light of the heightened standard announced in Bullock, it is appropriate to allow the parties an opportunity to present evidence, and for the bankruptcy court, familiar with this case as a whole, to handle the fact-intensive question of whether debtor’s actions were taken in bad faith or were grossly reckless.

The carrier argues in the alternative that the default judgment entered in the state court should be given a collateral estoppel effect as to plaintiff’s alleged defalcation.  The court concludes the question of whether debtor defalcated while acting in a fiduciary capacity was not actually litigated in this breach of contract and indemnity suit, as the circuit court was not required to resolve the question of defendant’s state of mind or find that defendant acted in a grossly reckless manner in order to enter judgment.

The court vacates the order of the bankruptcy court in part and remands based on the holding in Bullock. The court affirms the bankruptcy court’s holding that the circuit court’s default judgment does not have a preclusive effect on the issue in this case.

Cincinnati Ins. Co. v. Chidester (Urbanski) No. 5:13cv63, Aug. 27, 2013; USDC at Harrisonburg, Va. VLW 013-3-428, 9 pp.

VLW 013-3-428

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